A recent credit default swap (CDS) payout event, humorously highlighted by The Daily Show, actually opens a much larger issue, pointing to a core problem with unregulated OTC swaps whose notional value exceeds $600 trillion and dwarfs the world GDP by more than five times. If any unknown event were to trigger a large percentage of these CDS into default the result would be an economic nightmare of unmanageable proportion, making examination of the weak trigger points and inability to hedge risk in many swaps a valid concern.

A Spanish firm received remuneration from a third party if they made a late loan payment. Both parties benefited from this missed payment because it triggered the equivalent of an “insurance payout.”

Based on published press descriptions and comments from those involved, the ten second description of what happened is: A Spanish firm received remuneration from a third party if they made a late loan payment. Both parties benefited because it triggered the equivalent of an “insurance payout.”

The Daily Show compared this to a scene from the movie “Goodfellas” where the mobsters burnt down a restaurant to collect the insurance premium.

The Spanish company in the story was Codere, a small but well connected firm that owned horse tracks and betting parlors throughout Europe. The firm encountered financial struggles resulting from a recent public smoking ban that had seen its attendance, revenue and bond ratings plummet – a case study in the need for why a lender would want CDS insurance protection from loan default. Through a subsidiary, Blackstone Group, the world’s largest private equity firm, purchased Codere debt and also purchased CDS insurance against Codere defaulting on their loan agreement. The trade was essentially a relative value basis trade benefiting from the differential in pricing and yield of the bonds and the cost of the CDS insurance. Unknown is the cost of the CDS insurance, but it was said to be considerably less than the bond yield. But a significant benefit also came to Blackstone Group and other firms that purchased the CDS insurance when Codere missed the payment. According to a story first published in Bloomberg, Blackstone’s GSO Capital Partners subsidiary received approximately a $15.6 million payout from the CDS insurance but the total payout to all CDS holders resulted in $197 million. This payout occurred when Codere is said to have intentionally made a August 2013 bond payment two days after the 30 day grace period. After the CDS payments were triggered, Codere was able to more successfully re-negotiate its debt.

Primack used the word “convince” to term the decision process on why Codere defaulted. Did Codere receive clear payments in a specific if / then transaction?

After The Daily Show essentially lambasted Blackstone for engaging in what it termed “legal fraud” it then took many in the mainstream business media to task for not reporting on Wall Street financial crime. This drew a response from many in the media, some of whom said the size of the fraud at nearly $16 million was not noteworthy, despite the fact the total loss from the CDS insurance was pegged at $197 million. Fortune Magazine writer Dan Primack , who gave a voice to Blackstone’s defense, failed to mention this larger and more newsworthy loss number, focusing only on Blackstone’s situation, and also papered over the key point about Codere receiving compensation to make a loan payment two days late. Primack used the word “convince” to term the decision process on why Codere defaulted. Did Codere receive clear financial benefit or payments to their clear benefit in a specific if / then transaction, or, as Primack implies, was Codere’s decision to make a payment two days late a result of verbal deliberation without clear quid pro quo?

Depending on how the CDS contract was written, Codere receiving payment and signing a specific contractual agreement to technically default on a loan payment to trigger CDS insurance could be one of the most material aspects of the issue. Yet the Primack article is vague on this point. The Daily Show makes the clear assertion that Codere received a payment to default on the loan and a formal agreement was in place regarding same.

Another key issue left unaddressed was the identity of the issuer of the CDS insurance.

Another key issue left unaddressed was the identity of the issuer of the CDS insurance. Who were the participants that took the $197 million loss? Sources say and general speculation is the CDS were written by new entrants into the CDS game, not the traditional large banks. Was the new competition being given rough treatment that has been a hallmark of new competition entering the CDS market? Keeping swaps private and competition to a minimum has been basically a generally unreported battle that extends back to 1998 when then CFTC chairwoman Brooksley Born was ousted because she called for transparency into the dark market. As Bloomberg pointed out, “Default swaps were blamed by the Financial Crisis Inquiry Commission for contributing to the worst credit meltdown since the Great Depression…”

Another issue left unaddressed was the legal work behind the underwriting of the CDS.

Another issue left unaddressed was the legal work behind the underwriting of the CDS. Sources have indicated what might be considered a questionable legal contract could have cost the CDS issuer(s) $196 million because it did not take into consideration significant default considerations. Who was the law firm that wrote the CDS contract? Watch for a potential legal liability suit to ensue, as sources with experience writing CDS contracts have indicated the contract appeared to be a “rookie mistake.”

With over $600 trillion in swaps underlying the world economic system, swap default will likely become a more important economic issue

With over $600 trillion in swaps underlying the world economic system, swap default will likely become a more important economic issue, particularly if world interest rates rise sharply and the asymmetrical hedges employed by swaps issuers potentially fail. The large majority of CDS are insured by firms that have traditionally benefited from a government failure guarantee backing. To protect against catastrophic loss, when an issuer of a CDS swap issues insurance, they typically seek to hedge their risk. Many times there is not exact or even close hedge for the risk and the CDS issuer, so they engage in asymmetrical hedging in markets that are closely tied to but not exactly the same as the risk the CDS insures against. To provide a very basic example of asymmetrical hedging, a CDS writer who insured against rising rates in Greece might have sold insurance against rising Greek rates while taking the opposite position in French interest rates which are traded on a regulated exchange. While many of the CDS hedges are more sophisticated, the core risk in asymmetrical hedging is that a dramatic rise in on leg of the hedge, Greek interest rates for instance, reacts differently than the hedging mechanism, in this example French bonds. In the case of Codere, one example of an asymmetrical hedge could be the stock price. A company issuing CDS insurance could also sell short the stock. If the firm’s fundamentals deteriorated to the point they could not pay on their loans it would likely be reflected in a declining stock value. Executing hedges with smaller companies in sometimes illiquid situations can be difficult. The more difficult the CDS hedge the more expensive the CDS insurance.

Another key component of the Codere example is the fact that the contract lacked standardization.

Another key component of the Codere example is the fact that the contract lacked standardization. In the regulated derivatives industry a key component is that all contracts are standardized and thus risk management can be more precisely executed. Most swaps, however, are one off contracts and the lack of standardization is a significant risk.

Credit default swap is a term that typically generates a glazed look of confusion from even sophisticated financial professionals. However, with the potential to significantly harm the world economy in a rising rate environment, mainstream exposure of the Blackstone / Codere CDS provides a peak into an issue that will likely re-appear in the future with more significant consequence than the loss of $196 million.

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